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Journal of Banking & Finance xxx (2014) xxxxxx

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Journal of Banking & Finance

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Bank pay caps, bank risk, and macroprudential regulation

John Thanassoulis
Warwick Business School, University of Warwick, United Kingdom1

a r t i c l e

i n f o

Article history:
Received 13 June 2013
Accepted 4 April 2014
Available online xxxx
JEL classication:

a b s t r a c t
This paper studies the consequences of a regulatory pay cap in proportion to assets on bank risk, bank
value, and bank asset allocations. The cap is shown to lower banks risk and raise banks values by acting
against a competitive externality in the labour market. The risk reduction is achieved without the possibility of reduced lending from a Tier 1 increase. The cap encourages diversication and reduces the need a
bank has to focus on a limited number of asset classes. The cap can be used for Macroprudential Regulation to encourage banks to move resources away from wholesale banking to the retail banking sector.
Such an intervention would be targeted: in 2009 a 20% reduction in remuneration would have been
equivalent to more than 150 basis points of extra Tier 1 for UBS, for example.
2014 Elsevier B.V. All rights reserved.

Bank regulation
Financial stability
Bankers pay
Bonus caps
Capital conservation buffer

1. Introduction
The remuneration of bankers and executives in the nancial
sector is the focus of signicant regulatory attention in the UK,
EU and globally. Many are concerned that the level and structure
of pay contributes to the riskiness of banks. This concern has
inspired the Financial Stability Boards Principles for Sound Compensation Practices; the adoption by the European Union of the 1-to-1
Bonus Rule; and the adoption in Basel III of a Capital Conservation
Buffer which prevents banks making some remuneration payments
if their Tier 1 capital should fall below a specied level.2 The level
of pay is indeed a signicant cost for banks. Thanassoulis (2012,
Figs. 1, 3, and IA.1) documents that for a substantial minority of
nancial institutions remuneration exceeds 30% of shareholder
equity; while non-nancial rms rarely pay this much. For some
nancial institutions pay as a proportion of shareholder equity is
much higher and sometimes in excess of 80% of shareholder

Oxford-Man Institute, University of Oxford, Associate Member and Nufeld
College, University of Oxford, Associate Member.
Tel.: +44 2476528098.
E-mail address: john.thanassoulis@wbs.ac.uk
URL: https://sites.google.com/site/thanassoulis/
For discussions of these interventions please see FSB (2009), Thanassoulis (2013b)
and BCBS (2010).

This paper studies the impact of a cap on total remuneration for

bankers in proportion to the risk weighted assets they control.
Such a cap could be targeted, affecting some sectors, such as the
wholesale side, and not others, such as the retail side. Thus the
cap can work with existing regulatory attempts to treat wholesale
and retail banking separately (the Independent Commission on
Banking ring-fence in the UK for example).
The analysis demonstrates that a variable pay cap in proportion
to assets leans against the competitive externality which drives
pay up. Such a cap acts to lower aggregate remuneration. Hence
banks will have increased resilience to shocks on the value of their
assets due to their reduced cost base. This reduction in bank risk is
achieved whilst increasing bank values.
In principle banks can always be made less risky by increasing
their capital adequacy ratio. But by encouraging banks to meet
such requirements by either avoiding lending risk or reducing
lending, such a direct intervention has a cost. The intervention in
the labour market for banks increases bank values and does not
compromise lending. Further, to the extent that there is a broader
desire to intervene in the labour market for bankers, it would be
desirable if any such intervention had the effect of improving
nancial stability.
Basel III has determined, through the Capital Conservation Buffer,
that banks incentives to pay out rather than retain earnings needs
to be managed. Leading scholars have argued that the amount
banks paid out in share buybacks and dividends was so large as

0378-4266/ 2014 Elsevier B.V. All rights reserved.

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J. Thanassoulis / Journal of Banking & Finance xxx (2014) xxxxxx

Table 1
Remuneration reduction expressed as a gain in Tier 1 ratio.
Reduction in aggregate bank remuneration







Average equivalent increase in Tier 1 levels (basis points)






Notes: The table expresses the money saved by a hypothetical reduction in the aggregate pay bill expressed as the equivalent increase in Tier 1 equity. This is calculated by
determining the dollar saving from a given percentage reduction in the total pay bill and dividing by the total risk weighted assets. Data from Bloomberg, see Footnote 3.

to materially inhibit real economy lending through the last

nancial crisis (Acharya et al., 2009). Thanassoulis (2012) documents that the banks in this study typically paid out double the
amount in remuneration than they did on share buybacks and dividends, and the shareholder payments only grew to be comparable
to remuneration during the last crisis. Thus if payments to shareholders became high enough to be a concern to the well functioning
of the banking system, the aggregate wage bill is at this elevated
level of note permanently. To determine more quantitatively the
scale of the relevance of remuneration to nancial stability let us
suppose the total remuneration bill could be reduced by some percentage. One can calculate how much of an increase in the Tier 1
capital ratio this reduction in remuneration would represent by
comparing funds saved to total risk weighted assets. As remuneration falls during crisis periods I focus on crisis years to avoid misleading estimates of the importance of remuneration. Table 1
considers the remuneration paid in 2008 and 2009, during the last
nancial crisis, by the top 100 global banks ranked by asset value in
2011.3 If the total remuneration bill was cut by only 5%, then this
would be equivalent to an average increase in Tier 1 equity levels
of 9 basis points. If the remuneration bill could be cut by 20% then
the equivalent increase in the Tier 1 ratio would be 37 basis points
on average.
Table 1 demonstrates that lowering pay has only a modest effect
on an average banks resilience. The average however hides wide
variation amongst individual banks. Thus an intervention on pay
would be targeted. It would make the banks with the most unsafe
pay levels, safer. Fig. 1 displays the identity of the 20 banks (in
the top 100) who would have been helped most by a 20% reduction
in remuneration costs on their 2009 remuneration bill. Fig. 1 demonstrates that an intervention in the level of remuneration would
have helped some major household names which were the focus
of considerable regulatory attention during the crisis. For example,
a 20% reduction in the remuneration bill in 2009 would have been
equivalent to a Tier 1 increase at UBS of 1.5% (150 basis points), 1.3%
for Credit Suisse, and over 0.8% for Deutsche Bank. These are significant gures in the context of the Tier 1 requirements of Basel III.
Thus an intervention which lowered market remuneration levels
and increased bank values would have an arguably signicant and
targeted effect of lowering risk in the nancial system.
In a market, such as the labour market for bankers services,
competition to hire scarce talent leads to an externality. The market level of remuneration will be determined by the institution
which is the marginal bidder for the banker. By bidding to hire a
banker unsuccessfully, the marginal bidding bank drives up the
market rate of pay in the nancial sector. The bidding is a pecuniary externality: the banker gains, the employing bank loses. However, in addition the employing banks fragility to market stress is
increased by increases in its cost base. This lowers the value of the
employing bank further. This latter competitive externality represents a market failure. A bank failure makes other bank failures
more likely, and in addition can have negative consequences for

The data sample is the top 100 listed institutions in Bloomberg by total assets in
2011 for which relevant data exists and whose activities include banking. Only group
entities were included; public institutions such as central banks and development
banks were excluded. Of the 100, a sample of 80 banks remain. The list includes the
31 Globally Systemically Important Financial Institutions dened by FSB (2011).

both savers and borrowers. These further externalities magnify

the importance of the market failure.
A cap on pay in proportion to assets impacts on the marginal
bidding bank more than the employing bank. As pay in a given
business line rises in proportion to the resources or assets being
managed, in equilibrium the marginal bidding bank does not have
a sufciently large pot of assets to attract the banker, and so is
unwilling to offer a large enough expected payment. The bank
which succeeds in hiring the banker will be able to do so at a lower
bonus rate as it adjusts the rate for the fact that it has a larger pot
of assets, and/or is an otherwise more desirable place to work. A
cap on the size of remuneration in relation to assets therefore
impacts the ability of the marginal bidder to drive up pay. Hence
the level of pay in the whole market is reduced.
As the proposed cap is on total remuneration, the measure
allows the bank to structure pay in the manner it considers optimal. Risk sharing features, such as bonuses, can be fully preserved
(Thanassoulis (2012)), as there is no requirement to force xed
wages up within the cap.
A cap on pay in proportion to assets will alter a banks asset allocation decisions. Within an individual business unit the manager
would like to be assigned as large a fraction of the banks assets
as possible as this would likely translate into the largest pay. This
effect exists whether or not there is a cap, and forces banks to
become focused on asset classes considered to be core so as to
secure the talent they desire. A cap in proportion to assets is more
binding on the marginal bidder than on the employing bank. Hence
each bank will nd that in its core business lines it is able to hire its
staff more cheaply as the marginal bidders are impeded in their
bidding. This allows the banks to row back on the specialisation
that had been necessary with unconstrained bidding, and so benet from increased diversication.
The cap could naturally also be a tool for macroprudential regulation as it can be used to encourage the re-targeting of banks
from some business lines to others. Suppose that a cap is imposed
on bankers managing wholesale assets, and not for those managing
assets on the retail side. Those banks which were the runners-up to
employ the best wholesale bankers become less aggressive bidders
due to the pay cap. This lowers the remuneration level of wholesale bankers and allows the banks which specialised in wholesale
banking to devote more of their assets to retail banking so as to
benet from diversication. Secondly some universal banks will
be competing against other non-bank nancial institutions which
may be regulated under different rules. The presence of these institutions outside the regulatory net strengthens the macroprudential
tool. Regulated banks would be at a disadvantage in hiring the best
traders or wholesale bankers. Hence the expected return banks
would have from these wholesale activities would decline as the
banks would be unable to hire the most sought-after traders. Thus
banks would be even more incentivised to reassign assets at the
margin from wholesale towards retail banking.
2. Literature review
The objective of this paper is to investigate the consequences of
a regulatory pay cap on bank risk, bank value and bank asset allocation decisions. This work builds on Thanassoulis (2012) who

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J. Thanassoulis / Journal of Banking & Finance xxx (2014) xxxxxx

Fig. 1. Equivalent gain in Tier 1 ratio for the 20 most affected banks. Notes: The graph documents the impact of a 20% reduction in remuneration in the crisis year 2009. The
reduction in the remuneration bill can be measured in terms of an increase in the Tier 1 ratio. The graph documents the impact of such a reduction in remuneration on the 20
most affected banks in the sample of the top 100 banks used in Table 1. These are banks which would gain most resilience if the remuneration level of bankers could have
been reduced. Data from Bloomberg, see Footnote 3.

demonstrates the competitive externality operating though the

labour market which drives up pay and so increases bank risk. In
this study I extend the Thanassoulis (2012) framework to study
the effects of a regulatory cap on total pay in proportion to assets.
Further I extend the study to consider multiple asset classes,
asset allocation, and macroprudential regulation. The model of a
competitive labour market used here builds on the seminal contributions of Gabaix and Landier (2008) and of Edmans et al. (2009).
Relative to these works I explicitly model the possibility of bank
failure arising from poor asset realisations, and so am in a position
to discuss bankers and their impact on nancial stability.
As in Wagner (2009), if the size of the pool of assets should fall
below some level, a default event occurs which results in extra
costs for the bank. Wagner however does not investigate the supply side competition for bankers and so is silent on banker pay in
general. The aim of this paper is to understand how intervention
in the labour market for bankers would alter bank risk.
There is little empirical evidence on the level of bankers pay
and on bank risk. Cheng et al. (2010) is a notable exception which
demonstrates that nancial institutions which have a high level of
aggregate pay, controlling for their size, are riskier on a suite of
measures. A complementary nding is offered by Fahlenbrach
and Stulz (2011) who demonstrate that bank CEOs with the largest
equity compensation were more likely to lead their banks to losses
in the nancial crisis. Other empirical research has in general
focused on CEO pay and incentives whereas our focus here is on
remuneration more widely.4
This analysis focuses on the aggregate level of risk which a bank
would knowingly allow their bankers to take on rather than the
risk choices of individual bankers. Other studies have focused on
how competition between banks affects the shape of the remuneration contracts offered, and so individual bankers incentives to
take risks. For example Thanassoulis (2013a) argues that competition for bankers drives pay up and can lead to an industry using
contracts which tolerate short-termism. This work provides a
See for example Llense (2010) on CEO pay for performance, and Edmans and
Gabaix (2011) on the relative value of contract design versus hiring the optimal
individual to be CEO.

rationale for forced deferral of pay conditional on results. By contrast, Foster and Young (2010) argue that any variable pay can be
gamed and can lead to risk being pushed into the tails. Raith
(2003) considers rms competing, rather than banks, and endogenises the level of bonus to incentivise effort. He shows that rms
with larger market shares increase the bonus incentives they offer.
Benabou and Tirole (2013) consider competing rms using contracts to screen workers by ability: the high ability workers are
given incentives to take excessive risks. Acharya et al. (2013) study
the incentives a banker has to move institution to avoid their
employer learning whether their performance was due to skill or
luck. The insights in these works are complementary to the analysis here as none of these analyses explore the impact of pay caps on
the labour market equilibrium.

3. The model
Suppose there are N banks who have assets in a given asset class
of S1 > S2 >    > SN . Banks seek a banker who will maximise the
expected returns from their assets. If the banks assets in this class
should however shrink to be less than gS, for some g < 1, then the
bank incurs some extra costs. The parameter g measures a required
preservation rate on assets below which the bank, or its creditors,
take actions which generate a cost to the bank. This captures, for
example, the costs of forced asset sales to reimburse creditors, or
increased costs of capital. I refer to the case in which assets fall
below this critical level as a default event. I assume the banks costs
in the case of a default event are proportional to the initial level of
assets: kS. The functional form is chosen for tractability, but it is
not a key assumption. The key assumption is that costs of a default
event can arise if a banker shrinks the assets they are given to manage sufciently.
There are N bankers who can run this asset. They expect to grow
the assets they manage by a factor of a1 > a2 >    > aN . Thus if
banker i is employed by bank j then the expected assets of bank j
at the end of the period will be ai  Sj . An expected asset growth factor of ai 1 would imply that that banker i is only expected to
maintain the dollar value of the assets he or she manages. I assume

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J. Thanassoulis / Journal of Banking & Finance xxx (2014) xxxxxx

Table 2
Proportion of remuneration received as bonus.
Total compensation bands

500 K to 1 mn
> 1 mn



% Base salary

% Bonus

% Base salary

% Bonus





Notes: Data reproduced from Financial Services Authority (2010, Table 1, Annex A3.8). The FSA required this information of UK staff for seven major international banking
groups, and six major UK banking groups. The sample consists of 2800 staff comprising, the FSA estimate, 70% of Code Staff in banks operating in the UK. That is staff whose
activities can have a material impact on their employing bank. The table demonstrates that, given the exibility, banks would choose to deliver the vast majority of pay in the
form of bonuses.

that each bankers distribution of realised asset growth factors are

translations of each other so that bankers differ only in their skill.
Hence the density of asset growth factors delivered by banker n
can be written as fn x 1=an f x=an , where f  is a density with
unit expectation implying that the expectation of fn  is an . Integrating we have the cumulative distribution of the asset growth
factor given by F n v Fv =an . The outside option in the labour
market for bankers will be determined endogenously to this
model. In addition the bankers have the option of leaving this
labour market and, for example, moving to another industry or
location. I normalise this outside option to zero. Finally bankers
are assumed to be risk neutral. There is considerable evidence that
bankers may actually be risk loving (see the evidence contained in
Thanassoulis (2012)). However all that is required for the following
analysis is that bankers are not too risk averse.
As the bank is an expected prot maximiser, the shape of the
distribution of asset growth outcomes generated by the banker will
only be important if the resultant asset levels are low enough to
trigger a default event, leading to the extra costs described above.
In any empirically relevant calibration of this model, default will be
a low probability event. Hence the relevant probability will lie in
the tail of F n . I now follow Gabaix and Landier (2008) and
Thanassoulis (2012) and use Extreme Value Theory to characterise
the shape of a general distribution in its left tail. I assume that the
asset growth factor generated by the bankers is bounded below by
zero so that banks enjoy limited liability on their investments. In
this case the left hand tail of the distribution of asset growth factors can be approximated by

F n v  G  v =an c

Extreme Value Theory would require G to be a slowly varying function.5 I restrict to G > 0 being a constant. I require c P 1 so that the
distribution function takes a convex shape.
I restrict bankers to be paid in bonuses which are proportional
to the assets they control. Thanassoulis (2012, Proposition 1) demonstrates that banks, as modelled here, would prefer to pay fully in
bonuses rather than using xed wages as well as bonuses. Bonus
pay allows banks to share some of the risk of poor asset realizations with the bankers. This lowers the banks expected costs from
the possibility of realizations which trigger a default event. Table 2
presents evidence from the UK corroborating that this all bonus
restriction is a reasonable assumption, particularly for those earning the largest amounts. More recent regulatory interventions have
limited bonuses and required banks to pay staff using higher xed
wages.6 Table 2 shows that if banks are given the exibility they
would elect to pay staff overwhelmingly in the form of variable
This is not an explicit model of moral hazard, though the outcome of such models is compatible with these assumptions. As

See Resnick (1987). A function Gv is dened as being slowly varying at zero if

limv !0 Gt v =Gv 1 for any t > 0.
See Thanassoulis (2013b) for a discussion of the European 1-to-1 bonus

pay is delivered in the form of variable pay conditional on performance, managers are fully incentivised. The bonus rates delivered
by this model would be in excess of any bonus rates required by an
explicit model of incentives and moral hazard. Suppressing the
subscripts momentarily, if a bank with assets S hires a banker of
type a on bonus rate q then the banker expects to receive dollar
remuneration of q  aS. The expected asset level of the bank at
the end of the period, gross of the cost of any default event, is
a1  qS. Suppose the realisation of the asset growth factor is a.
There is a default event if the realisation, a1  qS < gS. Using
(1), the probability of this is Fg=1  q G  g=a1  qc . Hence
the expected value of the bank at the end of the period is EV

EV a1  qS  kSG


a1  q

Each bank will seek to maximise this expected value. A cap on the
remuneration in proportion to assets is equivalent to setting a maximum value for the bonus rate, q.
There is a competitive labour market for bankers. Banks bid
against each other to hire a banker to run their assets. Each bank
can offer a given banker a targeted bonus rate q which will be
applied to the realized level of assets the banker manages. The
offers are banker specic so that more able bankers can be offered
more generous terms. The market is assumed to result in a Walrasian equilibrium where an individuals pay is set by the marginal
bidder for their services. This can be modelled as the banks bidding
for the bankers in a simultaneous ascending auction (see
Thanassoulis (2012, 2013a)).
Finally I assume that the total size of each banks balance sheet
is exogenous. The assumption that balance sheets are exogenous is
equivalent to an assumption that the Board of a Bank would not
decide to change their aggregate size and debt-to-equity ratio to
allow an individual to be hired. Banks may well decide to alter
their asset allocation decisions within the envelope of their chosen
balance sheet size. We will explore this in detail below.7
3.1. Discussion of key assumptions
This model of banks competing for bankers is designed to be
tractable and to allow the key competitive forces which determine
pay levels to be clearly explained. Underlying the model are two
key assumptions. The rst is that the risk prole of the bank is
decided by the Board and not the banker, thus bonus rates do
not alter the tail risk of the institution. The second is that the bank
pays out remuneration to the banker, even if the banker delivers a
loss on the assets managed. This section will discuss each of these
assumptions in turn.
It would in principle be possible for a bank to stay within its regulatory Tier 1
ratios, and yet grow assets, to increase pay, by leveraging up with safe assets. This can
be managed here by appropriate risk weighting (Section 5.1). Further this more
general weakness in the regulatory regime is already being addressed through the
Leverage Ratio requirement in the Basel III framework.

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The Board of any bank will determine a desired risk prole for
their institution depending upon the return on equity they believe
their investors demand. The Board will seek to impose this risk
prole on the bank by using the corporate governance levers at
their disposal. These levers include the ability to manage the Value
at Risk (VaR) of individual bankers, often on a daily basis, and
broader asset allocation and hedging decisions. This study assumes
that these levers are sufcient to restrict the bankers to the desired
risk prole. Banker skill is therefore solely expressed as the
expected return given this shape of (tail) risk. If this risk control
assumption is violated then payment levels and bonus rates are
related to the risk prole of the institution. That is the tail risk F n
would be a function either of the bonus rate q, or of the expected
dollar remuneration.8 The dependence of tail risk on the remuneration would complicate the analysis offered here. When bidding to
hire a banker a large bank would be able to offer a low bonus rate
which, in the case of poor risk control, would lower the riskiness
of the bank. However larger banks will secure the services of more
talented bankers who have to be paid more, and this might raise
the riskiness of the institutions. The effect of poor risk control would
therefore be ambiguous for the solution of the model, even absent
any bonus caps. However the externalities described in this paper
would remain: the marginal bidder for a banker would increase
the fragility of the employing bank by raising her costs. This effect
would be exacerbated for larger banks if tail risk grows in remuneration levels, or may be mitigated if tail risk responds to bonus rates.
This study considers the impact of a cap on pay in proportion to
the assets a banker manages, and this cap is expressed as a cap on
the bonus rate payable. The intervention of a bonus rate cap studied here lowers bonus rates and overall pay levels. Therefore if
banks cannot fully control their tail risk then such an intervention
would mitigate the adverse effects of the poor risk control (see
Footnote 8). The lower bonus rates would reduce the incentive to
take excessive risk, to conduct fraud, to be myopic and to churn
across employers. Hence the analysis here understates the benets
of a bonus cap along all these avenues.
The second key assumption is that even if a bank should see its
assets shrink enough to trigger the costs of a default event through,
for example, forced asset sales, then the bank incurs a remuneration payment nonetheless. It might seem more realistic that a
banker who returns a lower level of assets than she began with
would not only not receive a bonus, but most likely lose her job.
If so then one might conclude that remuneration payments would
not add to a banks fragility, as when assets shrunk remuneration
payments would automatically be suspended until the threat of a
default event had passed. This reasoning is incomplete for a number of a reasons. Firstly, it may be that a banker who shrinks assets
loses her job, however consider the following thought experiment.
A banker running assets of 100 makes a 20% loss in the rst two
quarters and so is dismissed. The bank will need an alternative
banker to run these assets, suppose this replacement banker delivers 10% growth in the remaining two quarters. This second banker
would expect to be paid, and yet over the year assets have shrunk
from 100 down to 100  80%  110% 88, a reduction of 12%.
Thus remuneration is payable even if one believes that in banking
no failure is tolerated. Secondly, in reality a reduction in asset levels may well be due to bad luck and wider economic forces, rather
than poor banker skill. Indeed bankers would invariably argue this
This may be because high bonuses are used to separate high ability from low
ability bankers with the former incentivised to take excessive risks (Benabou and
Tirole, 2013; Bannier et al., 2013); or it may be because bankers game bonus schemes
through legitimate and illegitimate schemes (Foster and Young (2010)); or it may be
because bonuses provide an incentive for bankers to take early risks and then jump to
a new employer before their ability is revealed (Acharya et al. (2013)); or it may be
because bonuses encourage bankers to push risks into the future so inducing myopia
(Thanassoulis (2013a)).

to be the case. Thanassoulis (2012, Figure 2) demonstrates that

bankers were paid very large sums on average in the recent past,
even after delivering negative returns on equity. Finally, unless
the bank formally enters bankruptcy protection, remuneration
contracts have to be honoured. A bank may also wish to honour
implicit rather than explicit commitments as any failure to do so
would alter all employees expectations of their pay and lead either
to demands to make implicit commitments explicit in contract
terms, or lead to the departure of staff. Thus I conclude that the
assumption that remuneration is payable even if a bank incurs
the costs of a default event is appropriate.
4. The no intervention benchmark
The level of pay a banker enjoys in the market is set by the marginal bidder for their services. A bank, in deciding how much to bid
for a banker, trades off the cost of employing the banker as against
the increase in value the banker generates, net of any changes to
the expected costs of a default event, as compared to the next best
hire. This section will determine the market rate of pay as a function of fundamentals.
Lemma 1. The bank with the nth largest assets to be managed will
hire the banker of the same rank n. Thus there will be positive
assortative matching.

The lemma follows by showing that a bank recruiting a manager to manage a large pot of assets would be willing to outbid a
bank which is recruiting a manager to oversee a smaller pot of
assets. This is not immediate as we are in a setting of non-transferable utility. Greater pay for a banker increases the expected costs of
default. This loss of value to the bank is not a gain to the banker.
The bank recruiting for the smaller set of assets will bid for their
rst choice of banker up to the point where the extra value generated on their assets as compared to the next best banker is just outweighed by the extra costs incurred in remuneration to the banker.
A bank recruiting for a larger set of assets would have the skill of
the better banker applied to a larger pot of assets. In addition,
increases in banker skill raise the expected asset growth and so
lower the probability of a default event. As default costs are
increasing in the size of the assets managed, the reduction in the
expected costs from default is more substantial for the bank
recruiting for a large pot of assets. Hence, for both reasons, the larger bank would value the better banker more, and so the bank
recruiting for the larger pot of assets would win in bidding for a
given banker. It follows, by induction, that there will be positive
assortative matching with bankers being assigned in equilibrium
to banks according to their rank.
In this benchmark case bankers are indifferent to the identity of
their employing bank and select their employer based on their
expected pay. The analysis offered here is essentially unchanged
if banks differ in non-nancial ways. For example banks may not
all offer an equally pleasant work environment, or banks may not
all offer equally compelling long-term career prospects. Suppose
that if a banker works at bank i, then bank specic differences raise
the utility generated for the banker by a factor of si . Thus if the
bonus rate were q then the bankers expected utility at bank i
would be 1 si qaSi . In this case it is as if the banker were managing utility adjusted assets of Ri 1 si Si . The banks could be
re-ordered according to fRi g. We would then have positive assortative matching by utility adjusted asset size. The results in this
paper would be unaffected by this change.
It follows that the marginal bidder for a banker of rank n is the
bank of rank n 1. We are therefore in a position to solve for the
market rate of remuneration for all of the bankers:

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Proposition 2. The banker of rank i will be employed by bank i and

will receive an expected payment of qi  ai Si where the bonus rate qi is
given by:


Sj aj1  aj
ji1 i

Proposition 2 follows by an inductive argument. The amount

bank i needs to pay to secure the banker of rank i depends upon
how much bank i 1, one down in the size league table, is willing
to bid. This is the marginal bid which needs to be matched. The
amount bank i 1 is willing to bid depends upon how much bank
i 1 must pay for its banker, which in turn depends upon the bidding of bank i 2. Hence the market rate can be established by
Having established the market rates of pay through Proposition
2 we can now interrogate the impact of regulatory interventions on
the entire market.
5. Effect of a pay cap in proportion to (risk weighted) assets
Let us now consider a policy intervention which caps the pay of
the individual running this asset class to no more than a proportion
v of assets. As I have assumed good corporate governance of bank
risk, the optimal bank risk prole which maximises returns is
unchanged. So the Extreme Value approximation (1) continues to
hold. Analysis of the new market equilibrium yields that such a
regulatory intervention would have the following effects.
Proposition 3. Consider a mandatory cap on the remuneration of the
banker equal to at most a bonus rate v as a proportion of assets.
1. The intervention lowers bank risk and raises bank values for all
except the smallest banks.
2. The lower the remuneration cap as a proportion of assets, the
greater the positive impact: higher bank values and lower bank risk.
3. The equilibrium allocation of bankers to banks is not affected, preserving allocative efciency.
In the labour market, banks compete with each other to hire
scarce talent. The market rate of pay for a banker will be determined by the institution which is the marginal bidder for the bankers services. By bidding to hire a banker unsuccessfully, poaching
banks drive up the market rate. The bidding is a pecuniary externality: the banker gains while the employing bank loses. However,
there is also an increase to the employing banks fragility to stress,
due to increases in its cost base. The larger cost base due to pay
increases the probability of a destruction of assets beyond the
required preservation level, and so increases the expected cost of
this event. This lowers the value of the employing bank further
and is a competitive externality. The cap works by leaning against
this competitive externality.
The cap impacts the marginal bidder for any given banker more
than the equilibrium employer. The remuneration enjoyed by a
banker is set by the amount the marginal bidding bank is prepared
to offer. Lemma 1 demonstrated that a larger bank would be willing to bid most, yielding positive assortative matching. It follows
that the bank which succeeded in hiring a banker in equilibrium
will have been able to do so at a lower rate as a proportion of
the assets the banker will run. The preferred bank adjusts the rate
it offers down for the fact that it offers the banker more resources
and opportunities to make prots, and/or is a more desirable place
to work.
A cap on pay in proportion to assets impacts the ability of the
marginal bidder to drive up pay. This lowers the marginal bid

and so allows the employing bank to hire the banker they would
do absent the cap, but at a lower level of remuneration. Hence
the market rate of pay is reduced. This reduction in pay increases
the value of the bank directly as they secure their equilibrium
employee more cheaply. In addition the reduction in the remuneration payable lowers the banks fragility as less remuneration must
be paid out when the bankers realized results are poor. This reduction in risk also raises the value of the bank.
As the employing bank now secures greater value from the
banker they hire, in equilibrium, to run their business unit, the surplus the bank is willing to bid to hire marginally better bankers is
reduced. The reduction in the competitive externality, and the corresponding reduction in bank risk therefore propagates upwards
through the labour market.
It follows from the logic of the intervention that the more
severe the cap, the greater the impact on the marginal bidder,
and so the greater is the gain for bank values, and the greater the
reduction in bank risk.
As the cap applies to all banks in proportion to assets, it does
not alter the matching of bankers to banks. No allocative inefciency is introduced into the system. However, the benet requires
macro not micro prudential regulation. No single entity can secure
the risk reduction and value increasing benets alone, as these
arise from altering the value of the competing remuneration offers
for any given banker.
The remuneration cap will lower market rates of pay for bankers. In principle one might therefore be concerned that this will
lead to a departure of workers from nance to other industries.
However education-adjusted wages enjoyed by workers in nance
have out-stripped other industries since 1990 by a premium of
between 50% and 250% for the highest paid employees (Philippon
and Reshef (2012)). Thus I conclude that wages in nance could fall
by some margin before the general equilibrium labour re-allocation effect would become a problem.
Salary caps have been a feature of sports remuneration in the
US. However these are different to the proposal outlined here.
Sports salary caps are the same across all teams,9 while the intervention studied here links pay caps to the size of the assets managed.
This link to bank size is critical in ensuring the cap targets the negative externality created by the marginal bidder, and ensuring that
the cap does not create a distortion in the allocation of talented
bankers to banks.
Finally, it has been noted that the nancial sector has undergone a period of sustained consolidation and merger activity dating
back to before the 1990s.10 This consolidation in the banking sector
has been accompanied by a sharp increase in the size of the balance
sheets of the largest banks (Morrison and Wilhelm (2008)). The
model of the banking labour market we study here captures one reason bank mergers create value: the desire to grow the balance sheet
to allow more talented bankers to be hired. The pay cap studied here
does not necessarily strengthen this merger incentive. Whether it
does so depends on the particular parameter values.11

See for example 2013 NFL salary cap breakdown by team, USA Today, available
at http://www.usatoday.com/picture-gallery/sports/n/2013/09/13/2013-n-salarycap-breakdown-by-team/2808245/.
For example, Bank for International Settlements (2001, Table 1.1, p34) document
that in 1990 there were 8 M&A deals involving banks in one of the 13 countries
studied with a value in excess of $1 bn, and the average value of these deals was
$26.5 bn. Over the decade this activity grew, and by 1998 there were 58 M&A deals in
that year with a value in excess of $1 bn, and the average value of these deals had
risen to $431 bn.
For an example of merger becoming less protable with a bonus cap consider a
duopoly of banks. Merger (to monopoly) will have the merged bank hiring the best
banker and offering a bonus at the normalised rate of 0. This is unaffected by a bonus
cap. Pre-merger a bonus cap can increase the value of the larger bank, hence lowering
the incentive to merge.

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5.1. Assets to be valued on a risk weighted basis

The analysis has explored the case of good corporate governance under which the risk prole of the bank is set to maximise
the banks value. To ensure the robustness of the regulatory pay
cap, I now consider how a banker would seek to distort the value
maximising risk prole of a bank if their objective was to maximise
the money available for remuneration.
In this Section I will use the PyleHartJaffee approach to modelling the bank as a portfolio manager.12 Formally suppose a bank
wishes to maximise the value generated from
 m securities with the
returns on security j 2 f1; . . . ; mg denoted ~r j . If the bank selects allo 
cations in dollars of xj then next periods assets will be e
S j xj~r j .
These returns are assumed jointly normally distributed with vector
of expected returns q and the variance-covariance matrix V. Hence

l E eS

xj qj

var e
S hx; Vxi

The PyleHartJaffee approach assumes that the value function of

the bank can be decomposed into a function of only the rst two

moments of the returns distribution: U l; r2 . If the bank selects
the riskiness of her portfolio, as assumed here, then the rst order
condition of the banks optimisation problem would yield

@U @ l @U @ r2

@ l @xi @ r2 @xi
This can be written
in matrix notation as kq Vx 0 where

k @U=@ l=2 @U=@ r2 . Hence the bank would select an allocation of assets for the banker to manage proportional to V1 q.
I now assume that the banker managing these assets must be
paid an amount W for past performance. Suppose that any cap
on remuneration
applies to the weighted sum of security values
b; x with vector of weights b. Thus the pay cap regulation implies

W 6 v  b; x
To analyse the scope for banker induced distortion, suppose that the
banker can distort the risk prole of the bank, as long as he delivers

a value of the objective U l; r2 of at least R. As the banker wishes
to maximise his pay, his optimisation problem becomes


fx1 ;...;xm g


v  b; x subject to R U x; q ; hx; Vxi

Proposition 4. The ratio of allocations to individual securities is

unaffected by a pay cap if the cap weights securities proportionally to
their expected returns (b parallel to the vector of expected returns q).
The banker will be tempted to alter the investment prole he
targets if doing so can allow more to be paid under the cap whilst
preserving the expected returns net of risk. Proposition 4 shows
that this is not possible if the weights used to measure the quantity
of assets are proportional to the expected returns on those assets.
Hence if assets are weighted proportionally to expected returns,
the assumptions of this analysis remain robust, even if the banker
selects his investment strategy so as to maximise pay.
This analysis parallels that underlying the derivation of optimal
risk weights in capital adequacy regulation (Rochet (1992)). In the
standard CAPM framework, the expected return on a security
rewards the investor for the securitys undiversiable risk. Hence
Proposition 4 captures that the weight accorded to a security in
The PyleHartJaffee approach was proposed in Pyle (1971) and Hart and Jaffee
(1974). The version used here is derived from Freixas and Rochet (2008, Section 8.4).

the pay cap should grow in that securitys systematic risk. Rochet
(1992) argues that risk weights in capital adequacy requirements
should be proportional to the expected returns to ensure that the
bank will invest in an efcient portfolio of assets given the limited
liability constraint. To the extent that the Basel risk weights capture
systematic risk, they are a convenient approximation to this rule.13
6. Asset allocation responses to a pay cap
Banks invest in many asset classes. The banker managing an
asset class can make greater prots from a larger pot of assets.
Hence, even absent pay regulation, there exists an incentive to
try to manage as many assets as possible. This implies that in the
absence of any remuneration cap banks are under pressure to raise
asset allocations to areas where they seek to hire the best bankers/
traders. This increased asset allocation has a cost however in terms
of reduced diversication and excessive concentration.
This section will demonstrate that a remuneration cap does not
strengthen this effect, but rather weakens this excessive concentration effect amongst evenly matched banks, and so creates an
incentive for banks to re-assign assets so as to better diversify.
The cap impacts the marginal bidder in any asset-class more than
the equilibrium employer. It therefore hampers the extent to
which a rival bank can drive up remuneration in any given asset
class. This reduces the need to focus assets on a limited number
of core areas, and so allows for greater gains from diversication.
I demonstrate these results through an extension of the model
to allow for multiple asset classes.
6.1. Extension to a model of multiple assets
The diversication effect of bonus caps is at its strongest when
the competing banks are close in size. Later in this Section I will discuss the case of banks of very different size. To demonstrate this
positive effect of bonus caps most simply, consider initially two
banks each with equal total balance sheet size of T. Consider a model
of two available asset classes, and within each asset class there are
two bankers who could run either banks allocation to the asset class.
The most able manager in each class has an expected growth factor
of a, the next best hire has an expected growth factor of b < a. The
bankers outside options continue to be normalised to zero. The asset
level realisations in each asset class are assumed to be independent.
Each bank must decide how to split its balance sheet between
the available asset classes, assigning S dollars to one asset class
and T  S dollars to the other. To proxy for the benets of diversication parsimoniously I suppose that the banks gain value
c  ST  S on top of the assets realised within each asset class,
with the parameter c a constant greater than zero. The specic
functional form of diversication benet is for convenience, the
economic assumption is that diversication confers some benets
to the bank, and these benets fall away if the bank withdraws
from a given asset class. This assumption captures, for example,
that the volatility of returns in the normal course of business are
reduced which provides value for employee stock holders and
any other investors who are not fully diversied; alternatively
the assumption captures the effect of diminishing marginal returns
to any given asset class as more and more of the balance sheet is
used for that asset class. I model the banks as rst simultaneously
deciding their asset class allocations, and then competing to hire
the bankers as in the benchmark model given above.
However the risk weights offered in banking regulation are not a pure estimation
of systematic risk (Iannotta and Pennacchi (2012)). The Basel rules allow national
regulators some exibility in selecting risk weights, and where analysis is conducted
the risk weights are calculated to reect the overall expected loss conditional on a
default. The Basel risk weights will therefore be a good proxy for systematic risk only
to the extent that systematic risk is correlated with overall risk.

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6.2. Optimal asset allocation

Because of the symmetry of this initial problem I consider a
symmetrical allocation. I therefore consider an allocation of assets
in which each bank targets the best banker in a different asset class
by putting S > T=2 into the targeted asset class, and T  S into the
remainder. The expected value of a bank which secures the
a-banker in its targeted class for a bonus of qa , and the b-banker
in the other business line for a bonus of qb is given by

V S; T  S a1  qa S  kSG

a1  qa


b 1  qb T  S  kT  SG

c  ST  S


b 1  qb

Eq. (5) captures the costs of a default event in any asset class. Such
an event occurs if the assets under management in the class shrink
to be less than g of their initial level. Under a pay cap we require
qa ; qb < v.
Proposition 5. As the cap on pay becomes more severe (v declines),
banks re-balance their asset allocation in the direction of making their
exposure more diversied and less asymmetric.
The asset allocation a bank makes is a trade off between giving
the most assets to managers who can produce the highest return,
set against the costs of over-specialisation. To understand the
result it is perhaps easiest to consider the reverse, and suppose that
a remuneration cap becomes less binding. As the remuneration cap
is removed, each bank nds itself subject to more aggressive bidding for the best banker from the bank which is under-weight in
that asset class. To continue to employ the a-banker in its targeted
asset class, each bank must match the more aggressive bidding.
This lowers the prots available from the asset class, and it
increases the risk of a default event as well. If the bank now
increases its asset allocation to its targeted area then it can lower
the proportion of the realised assets used for remuneration. This
increases the banks value from this asset class because its risk of
a default event is reduced. Hence each bank responds to a relaxation of the pay cap by focusing more on its target asset class in
defence against the now more aggressive rival bank.
Running the process in reverse we see that as the remuneration
cap becomes more severe, it is the institutions which are already
most devoted to the class that are least handicapped. The cap is
more binding on the marginal bidder in each asset class than on
the equilibrium employer. It therefore follows that the leading
institutions in the class are in a position to reduce their asset allocation as they can continue to employ the best staff with fewer
assets, and stand to gain the diversication benets by re-balancing towards other asset classes.
Hence an effect of the pay cap intervention is that it reduces the
pressure for similarly matched banks to excessively focus on their
core areas, as would be necessary with unconstrained bidding.
The cap instead creates a force for diversication amongst the
banks. This benecial effect becomes weaker as the banks become
more asymmetric in size. To see this suppose that the two banks
studied in this section become sufciently asymmetric in size that
the large bank can secure the a-banker in both asset classes. In this
case one can show that the optimal asset allocation will be unaffected by the presence, or otherwise, of a bonus cap.14 The analysis
Both banks would split their balance sheets equally between the asset classes to
maximise the diversication benets. If the bonus cap is binding, then the smaller
bank will bid at most a bonus rate of v. The larger bank would secure the a-banker in
each asset class at a bonus rate of vT 2 =T 1 where T 1 > T 2 denotes the size of the total
balance sheet. The equilibrium bonus falls in the bonus cap as per Proposition 3.

in this case exactly parallels the single asset class analysis in Section 5.
A bonus cap impacts the ability of the marginal bidder to drive up
remuneration in both asset classes, allowing the larger bank to lower
its risk and increase its value with no asset allocation distortion.

7. Pay Regulation for macroprudential objectives

A cap on remuneration in proportion to assets can be applied to
some business lines and not to others. This section demonstrates
how such partial application of pay regulation can be used to retarget banks activities to certain asset classes. Suppose, as an
example, that for reasons outside of this model a regulator decided
that there was insufcient lending to the real economy via banks.15
In this case a pay cap in proportion to assets applied to bankers
working in wholesale banking, but not in retail banking, would alter
the equilibrium asset allocation decisions so that all banks refocus
assets away from wholesale and towards retail banking. Though a
pay cap is an instance of microprudential regulation, the effect
would be a macroprudential one as the resilience of all banks across
the system is improved.
Further banks are in competition with other Financial Institutions, such as hedge funds, to secure bankers/traders, and these
nancial institutions who do not possess a banking license are
often regulated under different rules. I will study the case of
incomplete regulatory coverage in Section 7.2. The existence of
nancial institutions outside the regulatory net, rather than being
a problem, can be used to further enhance the efcacy of pay-caps
as a macroprudential tool.
7.1. A model of partially applied pay cap regulation
Once again consider the model of Section 6 of two asset classes
and two bankers in each asset class with expected asset growth
factors a > b. For expositional purposes, and in keeping with the
motivating example, I will label the two asset classes r for retail
and w for wholesale banking. However the analysis applies to
any subdivision of banks activities. Generalising from Section 6, I
move away from symmetry and consider two banks with balance
sheets T r ; T w . I restrict attention to the interesting case in which
each bank secures just one of the a-bankers. Bank T r will specialise
in the r asset class (e.g. retail banking). It devotes Sr dollars to retail
banking, and T r  Sr dollars to the alternative asset-class: wholesale banking. Similarly bank T w specialises in the w asset-class
(e.g. wholesale banking), and so devotes Sw dollars to its asset class
specialism (the w asset class). Bank T r assigns more dollars to the r
asset class than the rival bank, and in this sense specialises in the r
asset class (retail banking).
Each bank secures gains from diversication (as in Section 6)
proxied by c  Sw T w  Sw for the wholesale focused bank, and similarly for the retail focused bank.
The regulatory intervention I analyse here is a bonus rate cap v
applied to remuneration on the w-asset class only. If this bonus cap
is binding then it will affect the marginal bidding bank in the w-asset
class. Hence the cap implies that bank r is restricted in the bonus rate
it can offer to try and attract the a-wholesale banker. Bank r can offer
the a-wholesale banker at most expected pay of v  aT r  Sr given
its asset allocation choice. The bonus rate paid by bank w for the
wholesale banker will be below the cap (13). There is no cap on
bonuses offered to bankers in the retail banking asset class.
I again model the banks as rst simultaneously deciding their
asset class allocations, and then competing to hire the bankers as
Insufcient lending in the UK to Small and Medium sized Enterprises (SMEs) has
been a notable recent regulatory concern. See for example Funding for Lending
failure dismays BoE, Financial Times, March 11, 2013.

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in the benchmark model given above. I restrict attention to the

benets of diversication large enough that

c > max

1 1
Sw Sr

k g c cc 1v2
2 a 1  vc2

This assumption delivers stability of the equilibrium allocation of

assets between classes. The assumption is trivially satised if the
banks are large enough.
We are now in a position to study the effect a partially applied pay
cap has on the asset allocation decisions of the two banks. I denote
the best asset allocation response of bank w to bank r as Sw Sr and
vice-versa. Thus if bank r assigns assets Sr to its specialism (the r
asset-class, retail banking), and by implication assets T r  Sr to
wholesale banking, then bank ws best response is to assign Sw Sr
to its asset-class specialism (the w asset class, wholesale banking).
Lemma 6. The best asset allocation responses of each bank are
strategic substitutes. Thus dSw Sr =dSr < 0.
The result builds on the logic of Section 6 and demonstrates the
strategic interaction between asset class allocation decisions. If
bank r should increase its allocation to its asset-class specialism
(r asset-class, retail banking), then by denition it is moving assets
away from the other asset class: wholesale banking. The rival bank
now faces a less aggressive bidder for the a-wholesale banker. As
explained in Section 6 the wholesale focused bank can now benet
from increased diversication and so reduces its focus to wholesale
banking. The wholesale focused bank therefore increases its allocation to retail banking. As there is no bonus rate cap on remuneration to retail bankers, there is now a second round effect making
bank w a more aggressive bidder for the a-retail banker. Therefore,
to protect its protability bank r optimally responds by further
increasing its asset allocation to retail banking also.
Bonus caps applied to wholesale banking can kick-start this reallocation process by inhibiting bank r from bidding up wholesale
banker bonuses:
Proposition 7. If a bonus cap applying only to one asset class is made
more severe, all banks increase their asset allocation to the alternative
asset class. Hence if a bonus rate cap v applying only to wholesale
banker remuneration is reduced, all banks increase their asset allocation to retail banking.
A bonus rate cap applied to one asset-class affects the marginal
bidders ability to drive up pay in this asset class. The retail-focused
bank is the smaller bank in the wholesale banking asset class, and
so it is the marginal bidder setting the remuneration level which
the wholesale-focused bank needs to match. A bonus rate cap for
bankers working in wholesale banking impedes the retail focused
bank from bidding up the remuneration of wholesale bankers. This
sets off the logic of Lemma 6. Namely the wholesale focused bank,
facing less intense competition to hire the a-wholesale banker, is
able to prot from diversication. Thus bank w, at the margin,
moves some assets away from wholesale and towards retail banking. This makes competition for the a-retail banker more intense,
and as there is no bonus cap to protect it, this leads to the retail
focused bank also repatriating some of its assets away from wholesale and towards retail banking. This effect is depicted graphically
in Fig. 2. Thus partially applied pay caps can be used to alter banks
asset allocation decisions through the economic cycle.

Fig. 2. Best response asset allocation functions. Notes: The curve Sw Sr captures the
best asset allocation response of the w focused bank on asset class w (wholesale
banking), in response to the allocation Sr of the r focused bank to the r asset class
(retail banking). The best response functions are strategic substitutes as the curves
slope down. As the bonus rate cap v on wholesale banker remuneration is made
more severe (v declines), the best response curve of the w bank is pulled down. The
best response curve of the r bank is not affected as there is no cap on retail banker
remuneration. Hence the equilibrium asset allocation to retail banking rises for
both banks.

tively to alter the equilibrium allocation of banks assets. Consider

therefore just one universal bank r active in both the r asset class
(e.g. retail banking) and the w asset class (e.g. wholesale banking).
The bank is once again regulated as to the remuneration it can pay
to bankers who manage assets within its wholesale banking book.
It is not regulated on payments to those managing retail banking
assets. Thus the pay cap regulation continues to be partially applied.
Now replace the universal bank w analysed in the section above
with a competing nancial institution active only in the w asset
class. I will refer to this institution, for the purposes of this example, as a hedge fund and label its assets in the class Sh . I assume this
h institution sits outside of the regulatory net and so is exempt
from the pay cap. (Otherwise the analysis above is trivially
extended). This model simply captures that banks have multiple
business units, and in some of the business units they will face rivals who come under a different regulatory regime. The benets of
diversication for bank r are again proxied by c  Sr T r  Sr if bank r
assigns Sr dollars to the retail banking book. In both asset classes
there continue to be two bankers with expected growth factors
a > b. (Only one retail banker will be required hence the a-retail
banker will be secured by bank r.)
The case of interest is where, absent any cap, the bank would
secure the better executive to run its wholesale business unit. Such
a bank is one which is vulnerable to the introduction of a remuneration cap which applies to it, but not its rival. To this end I restrict
attention to the case in which

Sh <

 c  c 

a  b kG

2 2c

This parameter restriction ensures that, absent any cap, the bank
would secure the a-banker for its wholesale banking book.
First I determine an upper bound on the size of the retail banking book in the absence of any regulation capping pay.

7.2. Macroprudential effects with incomplete regulatory coverage

Lemma 8. In the absence of a remuneration cap the bank will secure

the a-banker to run the wholesale banking book. The bank will set its
retail banking book strictly smaller than Syr where

In this Section I expand the analysis above to demonstrate why,

even with incomplete regulatory coverage, pay caps in proportion
to assets applied partially across asset classes, can be used effec-


 c  c 

a  b kG

2 2c

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The economics of Lemma 8 are readily explained. Suppose, for a

contradiction, that the bank only succeeds in hiring the b-banker to
run the wholesale banking book. Under this assumption the value
of the bank can be determined by adapting (5) as:

g c
W r Sr aSr  kSr G
bT r  Sr  kT r  Sr G
from retail book

c  Sr T r  Sr

Eq. (8) follows as both bankers will receive a normalised bonus rate
of zero. This value function is concave in the allocation of assets to
the retail banking book, Sr . Hence there is an optimal allocation
given by the rst order condition. This asset allocation is sufciently
large that the bank would have more assets in its wholesale banking
book than the hedge fund, given assumption (7). This delivers the
desired contradiction as the bank will outbid the hedge fund and
so secure the a-banker for its wholesale activities (Lemma 1).
It follows that, absent pay cap regulation, bank r will outbid the
hedge fund and hire the a-wholesale banker. As bank r must compete with the hedge fund to secure the wholesale banker, the awholesale banker receives higher remuneration than the a-retail
banker does. Thus, to protect its protability the retail bank diverts
assets to wholesale banking, shrinking its retail banking book. This
is not straightforward to show as the interaction between pay levels and bank default risk is not linear. Nevertheless it can be demonstrated that we have an upper bound on the retail banking book
in the absence of pay cap regulation, and this upper bound is given
in Lemma 8.
Proposition 9. If the bank is subject to a sufciently severe cap on
remuneration for the wholesale banking book then the bank will reallocate more assets to retail banking and reduce the size of its
wholesale banking book.
Proposition 9 considers a regulation which is sufciently severe
that the bank loses the best wholesale banker to the hedge fund. In
this setting the bank can secure bankers, but in wholesale banking
they are not the very best ones. As a result the expected growth
factor available from wholesale banking assets falls slightly, to
the lower level of b. The bank would now conduct its asset allocation decision as in the proof of Lemma 8 under the assumption that
it will secure the b-bankers for the wholesale banking book, and so
the optimal asset allocation can be found. At the asset allocation
stage the bank will choose, at the margin, to divert funds away
from the wholesale banking book and towards the retail banking
book as the returns from wholesale banking have diminished as
a result of the partially applied pay cap regulation. Proposition 9
captures that the incomplete regulatory coverage of remuneration
regulation can be turned to the regulators advantage. The ability to
use pay cap regulation as a macroprudential tool survives in the
presence of a porous regulatory net.
8. Conclusion
A variable cap on remuneration in proportion to risk weighted
assets lowers bank risk and raises bank values. Such a cap impacts
on the marginal bidder for a banker more than on the employing
bank. The implication is that the market rate of pay for bankers
declines, and so banks become less fragile as their cost base is
pulled down. By addressing a negative externality in the labour
market for bankers, the intervention also has the effect of dampening the pressure banks are under to focus resources on given asset
classes so as to secure better bankers. And the pay cap can be used
to achieve macroprudential objectives through the cycle as it can be
structured to encourage banks to refocus towards a subset of asset

Table 3
Numbers of employees targeted by intervention on top 20% of earners.
20% Of employees in 2009
Credit Suisse
Morgan Stanley
Deutsche Bank
Goldman Sachs


Notes: The table documents the numbers of employees which would have to be
captured by an intervention if it were targeted at the top 20% of earners in the
named banks in 2009. The data is drawn from Bloomberg and the dataset is that
used in Table 1 and Fig. 1. The banks displayed are a selection of household names
drawn from the top 20 banks documented in Fig. 1.

classes (e.g. retail banking) if desired by a regulator. Finally, by

using appropriate risk weights, bankers incentives to abuse any
weakness in corporate governance failings to grow pay is mitigated.
Consider therefore a regulatory intervention which capped total
bank remuneration summed over wholesale bankers proportional
to each banks risk-weighted wholesale banking assets. Regulation
at the aggregate level is easier and less costly to implement than per
person caps. And yet such a cap will likely be implemented by
senior management on rank-and-le hiring decisions as a top down
rule. This is because the numbers of employees involved would
make micro-managing deviations from a general rule impractical
(see Table 3). Hence a cap at the bank level tackles the externality
described at the individual banker level, and likely generates the
consequences for bank values and bank risk studied here.
As a benchmark calculation let us suppose that remuneration in
banks adhered to a commonly experienced 80:20 rule (Sanders
(1988)) so that the 20% best paid bankers secure 80% of the remuneration. If the pay of these best paid executives could be lowered
by a quarter then this would equate to a 20% reduction in the overall remuneration bill, the effect of which was graphed in Fig. 1.
Such a reduction in 2009 would have been equivalent, in safety
terms, to an increase in the Tier 1 ratio of over 150 basis points
for the most affected institution (UBS).
The logic, described in this analysis, of the negative externality
banks exert on each other through the labour market exists in all
industries. Thus one might wonder if a similar pay cap regulation
would be advisable in other industries beyond nance. I do not
seek to take a stand on this question. However I note that the rationale for intervening beyond nance is weaker for at least two reasons. Firstly the nance industry is special as compared to other
areas of business due to the negative externalities it exposes society to when nancial rms fail. These impacts on society are not
formally part of this model and so this study does not offer a justication that pay caps in banking are worthwhile. I purely note
that the case for pay caps in proportion to assets is likely to be relatively stronger in banking than in other industries. Secondly, the
nancial sector has a larger remuneration bill as a proportion of
shareholder equity than other industries. It therefore follows that
the gain from a pay cap in terms of bank risk reduction is correspondingly greater than it would be in other industries.
I would like to thank the editor Ike Mathur, and an anonymous
referee for detailed comments which have greatly improved this
paper. I would further like to thank Sam Harrington, Su-Lian Ho,
Victoria Saporta, Matthew Willison, and the other members of
the Prudential Policy Division at the Bank of England for helpful
discussions. I would also like to thank the Bank of England for their
hospitality whilst I was undertaking this research. Finally I am
grateful to audiences at the Financial Globalization and Sustainable
Finance Conference, Cape Town, the IFS School of Finance, the CFA

Please cite this article in press as: Thanassoulis, J. Bank pay caps, bank risk, and macroprudential regulation. J. Bank Finance (2014), http://dx.doi.org/

J. Thanassoulis / Journal of Banking & Finance xxx (2014) xxxxxx


Belgium, the CFA London, the Atlanta Fed, WBS University of Warwick, University of Zurich, and Christ Church, Oxford University.
This work does not reect the view of the Bank of England or
any other named individuals. Any errors remain my own.

We can now determine the equilibrium bonus paid by any bank

i. Let bank m be the bank with the greatest assets, conditional on
being smaller than bank is, which is affected by the cap. Thus
m 2 M and m > i. From (12) we have

Appendix A. Omitted Proofs

ai Si qi


Sj aj1  aj am1 qm1 Sm1


Proof of Lemma 1. Consider banks i and i  1 and bankers j and

j  1. We wish to show that the bank with the larger pot of assets
in this business unit will secure the better banker. Suppose the
outside option of banker j is u. If bank i hires banker j at a bonus
rate qi;j then the bonus must satisfy aj qi;j Si u. Hence bank is
expected utility would be, from (2):

V ij aj 1  qi;j Si  kSi G

aj 1  qi;j


Hence bank i is willing to bid up to a bonus of qi;j1 for banker j  1


V ij aj1 1  qi;j1 Si  kSi G


aj1 1  qi;j1


Setting (9) equal to (10), this has solution aj1 1  qi;j1

aj 1  qi;j . The maximum bid that bank i will make for banker
j  1 is therefore

qi;j1 1  aj =aj1 1  qi;j


The same working determines the maximum that bank i  1 is will

ing to bid for banker j  1 as qi1;j1 1  aj =aj1 1  u= aj Si1 .
The lemma follows by demonstrating that bank i  1 is willing to
bid to higher levels of utility for banker j  1:

aj1 Si1 qi1;j1  aj1 Si qi;j1

aj1 Si1  aj Si1 u

 aj1 Si  aj Si u

aj1  aj Si1  Si > 0

The inequality follows as, by assumption, Si1 > Si and aj1 > aj . It
follows that we have positive assortative matching. h
Proof of Proposition 2. Bank i 1 will be willing to bid for the
banker of rank i a bonus qi1;i given by (11) as
qi1;i 1  ai1 =ai 1  qi1 . This is the marginal bid for banker
i. Hence bank i will match the marginal bidder:

ai qi Si ai qi1;i Si1 ai  ai1 Si1 ai1 qi1 Si1



It follows, by induction that ai Si qi ji1 Sj aj1  aj SN aN qN .

The ultimate outside option of leaving the industry for all the bankers is normalised to 0 which yields qN 0. The result follows. h


Sj aj1  aj am1 vSm by 13



As the cap is binding on bank m by assumption, we have

v < quncapped
. Hence the bonus paid by bank i declines as a result
of the cap. The risk of a bank incurring a default event is
Gg=a1  qc . As the bonus q declines this probability also
declines. The value of the bank rises by inspection of (2). Hence
we have the rst result.
We now turn to the second result. We wish to show that the
bonus payable by bank i declines as the cap, v, falls. Suppose rst
that a reduction in the cap v does not alter the identify of the
highest rank bank, with assets in this business line smaller than i,
which is affected by the cap. If so the bonus bank i pays is given by
(14). This moves monotonically with v delivering the result.
Suppose now the cap is so stringent that it affects more banks.
Thus suppose the identity of the highest rank bank, with assets
~ where
smaller than i, which is affected by the cap becomes bank m
~ < m. The bonus payable by bank i can therefore be written,
from (12) as

ai Si qi


Sj aj1  aj am1


~  1 pays
The proof now follows by observing that the bonus bank m
~ This follows as
declines as a result of the cap now affecting bank m.
~ for banker m
~  1 is reduced by the cap. Hence the
the bid of bank m
bonus paid by i again moves monotonically in v. This delivers the
Finally, as the cap applies to all banks, the positive assortative
matching result of Lemma 1 is unaffected. There is no re-ranking of
the banks and so the allocation of bankers to banks is
unaffected. h
Proof of Proposition 4. Given the maximisation problem (4) forD
h D

mulate the Lagrangian L v  b; x g U x; q ; hx; Vxi  R
with Lagrange multiplier g. The rst order condition then yields
an expression for the optimal allocation x :

vb g

q 2 2 Vx 0

Hence we have
Proof of Proposition 3. We rst show that a bank will pay a
lower bonus rate to the banker they hire than they would bid
for a better banker. This follows from (11) as qi;i1  qi
1  qi 1  ai =ai1 > 0. Hence a cap will be binding on a banks
bidding for better staff.
Suppose that the cap affects the bidding of bank j for the better
banker j  1 for the subset of banks j 2 M. If bank j 2 M then the bid
for banker j  1 is a bonus qj;j1 v as the cap is binding. Hence
bank j  1 will secure banker j  1 at a bonus such that it matches
the utility offered by bank j : aj1 Sj v aj1 Sj1 qj1 , yielding

qj1 v Sj =Sj1 < v


If instead a bank ranked j were competing against a bank unaffected

by the cap, then the required bonus will also be unaffected by the
cap, and is given by (12).



2g@U=@ r2

The direction of the vector x varies in the cap v unless b is proportional to q yielding the result. h
Proof of Proposition 5. First we note that both banks choosing
exactly the same allocation in all asset classes so that they set
S T=2 is not an equilibrium. As the banks are equal in size, competition for the a-banker would push their expected pay up to the
point where both banks were indifferent between the a and b
banker. Thus it would be as if both hired b-bankers. This is
dominated by one bank moving e of their balance sheet to one of
the business lines. They would then secure some benet from an
a-banker which increases their prot.

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J. Thanassoulis / Journal of Banking & Finance xxx (2014) xxxxxx

The bank with the smaller asset allocation in any given class
will have T  S in the asset class. If the cap on remuneration is
binding v < 1  b=a then the bonus is limited and so the bid is
capped at expected remuneration of avT  S. Hence the bank
with the larger pot of assets secures the a-banker by offering a
bonus rate of q vT  S=S. The bank with a smaller pot of assets
in any given class will recruit the b-banker for a bonus of 0 as the
outside option is normalised to 0.
To identify the optimal asset allocation S we must ensure there is
no incentive to unilaterally deviate to a 
different allocation e
S. Denote
the value from such a deviation by V e
S; T  S where the second
argument captures the rivals weight in the asset class. From (5):


T S e
S  ke
V e
S; T  S a 1  v

a 1v e

@ 2 V .@ e
S@ e
S < 0. By the same logic as for @ 2 V=@ e
S@ v we have
@2V @ e
S@ T  S > 0. Combining we have determined that
dS=dv > 0, so the result is proved. h
Proof of Lemma 6. I will prove the result for bank w, the result for
bank r follows analogously. Bank r is subject to a bonus cap of v in
its bidding for the a-wholesale banker. This yields expected remuneration of avT r  Sr . Hence bank w secures the a-wholesale
banker by offering a bonus rate of q vT r  Sr =Sw . Hence from
(5) the value of bank w is:


T r  Sr
Sw  kSw G@ h
V w Sw ;T r  Sr a 1  v
a 1  v T rSS


bT w  Sw  kT w  Sw G

S Te
S b T e
S k T e


We rst establish that the value function, (15) is concave in the

asset allocation
 S. This follows if the term i is convex in S. To test
this dene h e
S by

h e
S :

By the proof of Proposition 5 the value function V w Sw ; T r  Sr is

concave in the asset allocation Sw . Hence the best response of bank
w is given by the rst order condition, @V w =@Sw 0. Analogously to

0 a  b cT w  2Sw kG

a  av TS


This is a hyperbola in e
S. Consider the arm in which e
S > vT  S
which is the relevant one as S > T  S. This curve is positive, down
h  ic
. As c P 1
wards sloping and convex. Now consider f e
S e
S h e
a sufcient condition for this curve to be convex is if

() 0 < 2gvT  S2 which is true:

Thus the objective function of the bank is concave and so has a unique
maximand given by the rst order condition. Hence an equilibrium is
achieved when @V=@ e
S evaluated at e
S S equals zero. This gives:

S; T  S 0 a cT  2S  b kG
!c (


a 1  v TS

1 c

v TS

1  v TS



1  v T rSS


T r  Sr
1  c 1v



V w Sw ; T r  Sr


V w Sw ; T r  Sr 0
dSr @Sw @ T r  Sr

Due to the concavity of the value function with respect to Sw ,

@ 2 V @S2w < 0. By algebraic manipulation one can conrm that
@ 2 V w =@Sw @ T r  Sr > 0 which implies that dSw Sr =dSr < 0 as
required. h
Proof of Proposition 7. Lemma 6 shows that the asset allocation
decisions are strategic substitutes. We rst show that decreasing
the bonus cap v pushes the reaction function of bank w down.


This denes the equilibrium level of assets in the two business

units, S and T  S, implicitly as a function of v.
We wish to determine the change in the asset allocation to the
over-weight asset in equilibrium. We have @V Sv; T  Sv=
S  0 which denes S as a function of v. We therefore have

g c


I now show that the best response curve, Sw Sr is downwards sloping to yield the required result. Taking differentials we have

2gvT  S
2gvT  S
S e
Sh e
0 < 2h e
2 e
a ~S  vT  S
a eS  vT  S

cSw T w  Sw 17

dS @ 2 V S; T  S @ 2 V S; T  S

S@ v dv
S@ e
S@ T  S

By algebraic manipulation of (16), @ 2 V @ e
S@ v > 0.16 Due to the
concavity of the value function with respect to e
S, we have that


V w < 0, and

@Sw @ v w


V w dS
@S@w @ v V w 0.



> 0 from the proof of Proposition 5 (using

Footnote 16). Hence dSw =dv > 0 as required. As the bonus cap does
not apply to retail banking, the reaction function of bank r; Sr Sw is
unaffected by v.
Reducing v will push the intersection of the reaction curves
towards greater retail banking assets if the equilibrium is stable
(Tirole (1988)) so that 1 < dSi Sj =dSi < 0 for all i j. This can be
conrmed by explicit differentiation of (18):

0 2c


c n
The result follows if a1
1  c 1v v is decreasing in v. Differentiating with
respect to v yields


g c
dSw Sr
cc 1 h

g c

cc 1 h


T r Sr

1  v T rSS

ic2 v

2 Tr

ic2 v

2 T r

 Sr 2 dSw Sr



a1  v

c "


1  v

And multiplying through by 1  v2 conrms that the derivative is negative.

Simplifying, for c large enough we guarantee that dSw Sr =dSr > 1.
In particular a sufcient condition for the result to hold is (6)
using the fact that T i  Si < Sj for ij by construction. The proof
that dSr Sw =dSw > 1 is analogous. Hence we have the desired
result. h

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J. Thanassoulis / Journal of Banking & Finance xxx (2014) xxxxxx

Proof of Lemma 8. First we demonstrate that the bank would

secure the better wholesale banker. Suppose, for a contradiction,
that the bank selects T r  Sr < Sh assets for its wholesale banking
book. In this case the value of the bank is given by (8). This is concave in Sr . The rst order condition for this expression would set
Sr Syr . Hence bank r would have assets T r  Syr in its wholesale
banking book. But this is in excess of the hedge funds assets, Sh
by (7). Hence we have a contradiction and so the bank must prefer
an asset allocation to wholesale banking which was sufcient to
secure the better banker.
With no remuneration caps the banker would be paid a bonus
rate of 1  b=aSh =T r  Sr , which follows from (12). Bank rs
expected value is then, adapting (17):

V r Sr ; Sh a 1  1  b=a

T r  Sr
T r  Sr

 k T r  Sr G@ 

a 1  1  b=a T rSS

A aSr


g c
 kSr G
c  Sr T r  S r


This is concave in Sr if i is convex, which is true by the method of

proof of Proposition 5. Hence the objective function of the bank is
concave and so has a unique maximand given by the rst order condition. The rst order condition with respect to Sr delivers

V r Sr ; Sh kG@ 
a 1  1  b=a T rSS
1  b=a
 41  c 
T r  Sr
1  1  b=a T rSS
g c
c  T r  2Sr

Algebraic manipulations deliver that dSdr V r Syr ; Sh < 0 using (7).
Hence the optimal size of the wholesale banking book is greater
than T r  Syr , and so the assets devoted to retail are below Syr , yielding the result. h
Proof of Proposition 9. The hedge fund is willing to bid up to a
bonus given by (11) as qh;1 1  b=a. Hence the hedge fund would
be willing to offer the a-banker an expected utility of up to
aqh;1 Sh a  bSh . To hire the better executive the bank needs to
match this remuneration. This occurs if aqr T r  Sr P a  bSh .
If the remuneration cap is binding on the bank then the better
executive can only be hired if T r  Sr P 1  b=aSh =v. Suppose
the cap is sufciently severe that the wholesale banking book is
optimally below this level.17 In this case the bank cannot outbid


the hedge fund. The bank will therefore secure the b-banker to run
its banking book. In this case the banks value is given by (8). Optimising this value over the asset allocation, the optimal wholesale
banking book size is then given as Syr . The wholesale banking book
has shrunk and the banking book grown by comparison with the
bound in Lemma 8. h
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This is true in the limit as v tends to 0. Therefore there is a range of bonus caps for
which it is true by continuity.

Please cite this article in press as: Thanassoulis, J. Bank pay caps, bank risk, and macroprudential regulation. J. Bank Finance (2014), http://dx.doi.org/